The FED buys U

The FED buys U - As a result of the open market purchase,...

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· The FED buys U.S. government bonds from the public ( an open market purchase) and sells bonds (an open market sale) by way of controlling the money supply. · We will see how this is done, assuming that…. o The public holds no additional cash, and o Banks wish to hold zero excess reserves · A banks holds some fraction of deposits in the form of reserves · Banks reserves = (the banks deposits at the Fed) + (the cash in its own vaults). · In addition, total reserves can be broken up into categories: required reserves (required by the Fed), and excess reserves (in excess of those required). · Total reserves: Required reserves + Excess reserves (or RR+Er · What do banks do with the remaining deposits?) · For the purpose of the example to follow assume RRR is .10 or 10 percent. (required reserve ratio) · The purchases 1000 dollars of U.S. government bonds
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Unformatted text preview: As a result of the open market purchase, what happens to the money supply as measured, say, by the M1. To answer theis question we need to keep trak of the changes in the balance sheets of banks. DD is demand deposit, or checking account The balance sheet has to balance So therefore: The banks holds onto 100 dollars which it is required to do by the RRR, and lends out 900 dollars to the market. This is because excess reserves dont do anything for the bank. Essentially we are creating money, because at the first banks RR 100 and loan was 900, so 1000 dollars is created. Then the second bank gets 900 dollars. RR is 90 and Loan is 810. The third bank gets 810 dollars. RR is 81 and Loan (or excess reserve) is 729. 1000 + 900 + 810 1000 (1/(1-.9)) equals 1000/ (1/10) or $10,000 NOTE: The money supply change is $1000/ 1-.9 or 1000/ RRR...
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This note was uploaded on 03/30/2008 for the course ECON 2006 taught by Professor Rdcothren during the Spring '08 term at Virginia Tech.

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